Here in India, the turnaround in the world view has been even swifter. We routinely berated our finance ministers for being spendthrift and blamed fiscal irresponsibility for all our macroeconomic problems. But when Nirmala Sitharaman announced a big borrow and spend programme in the last Budget, she was widely acclaimed for her boldness and sense of responsibility.
The FM didn’t say anything about debt sustainability, budgeted a higher than expected deficit of 6.8% of GDP for the coming year, and opted for a slower than expected medium term fiscal consolidation path. Yet, even staunch fiscal hawks thought that was par for the course.
What explains this astonishing shift in economic orthodoxy? Why has the fear that mounting debt is a sure-fire route to disaster given way to such nonchalance? No, it’s not economics that has changed; what’s changed is the real world to which economics applies. And that change predates the coronavirus.
In rich countries, the fundamental real-world change goes under the name of secular stagnation, a condition caused by structural factors such as ageing populations, rising inequality and slowing productivity. Older people who expect to live longer spend less per capita, as do low income households who don’t see their economic prospects improving. As people consume less and save more, investment opportunities decline and the economy goes into a low growth, low inflation syndrome of secular stagnation.
Central banks respond to this downturn by cutting interest rates to zero or even making them negative. When people’s confidence about their economic prospects is low, even that doesn’t help. As they say it’s like ‘pushing on a loose string’. The solution then, it’s argued, lies in governments taking advantage of low interest rates to borrow and spend. In a low interest rate scenario, the multiplier effect of spending will be so high that public debt, far from exploding, will actually pay for itself.
Does this logic apply to emerging markets, India in particular? Certainly not. Our structural factors are totally different. With a median age of 29 our population is young, our economy is consumption driven and inflation prone. Far from secular stagnation, any increase in incomes here quickly translates to consumption. And if production falls short of demand as it often does, we get inflation.
We differ from rich countries in terms of public finance dynamics too. In rich countries, interest payments are just a small proportion of total government spending and that fraction is declining. In India, because of accumulated debt, interest payments are the single biggest item of government expenditure and eat up more than 40% of total revenues, leaving that much less for spending on growth enhancing sectors like education, health and infrastructure.
So, how much debt is too much? If one works through the algebra, it will turn out that two conditions have to be met for debt not to explode. The economy’s growth rate has to be higher than the interest rate on the debt; second, the government must be collecting enough in taxes such that it’s borrowing, if at all, only for paying the interest on debt. In India, we meet the first condition but are far from meeting the second. This vulnerability pegs our sustainable debt at a low level.
After working through the feedback loops, the FRBM Committee determined our sustainable debt as 60% of GDP. As against that, it’s estimated our debt will rise to 90% of GDP by the time we exit the corona crisis. It’s this high level of debt and the low probability of tax revenues rising sufficiently to bring the debt ratio down that will weigh with rating agencies as they evaluate our medium-term prospects.
Can we be nonchalant about rating agencies’ judgment? Unfortunately, not. Ratings matter in shaping market perceptions, and adverse perceptions feed on themselves and spiral into self-fulfilling prophecies. History is evidence to this.
In his influential books on depression economics, Nobel laureate Paul Krugman says that leading into the 1990s Asian financial crisis Australia, a rich country, and the Asian economies, all of them emerging markets, had a similar risk build up. But the markets allowed Australia to make a smooth adjustment and avert a crisis, even as they denied a similar privilege to the Asian economies and pushed them into a devastating crisis. The short point is that markets are much less forgiving of policy excesses by emerging markets. It’s unfair but true.
For sure, going into the Budget, the FM was locked into an ‘impossible trinity’ of sorts. She had to spend more, not raise taxes and keep borrowing under check. Something had to give, and she chose to breach the borrowing limit on the calculation that the additional debt financed expenditure will generate rapid growth such that the debt will pay for itself.
That outcome is plausible but not inevitable. Our growth prospects and hence our debt sustainability depend critically on private investment pouring in. For that to happen, we need a lot more things to fall in place than just a well-crafted and well-intentioned Budget.
If today’s debt financed spending does not generate rapid growth, the burden of debt repayment will pass on to our children through higher taxes. We don’t want to sin against our children!